So, you're ready to take the leap and become a home owner. For most of us, homes come with mortgages. These large loans take decades to pay off and cost thousands of dollars in interest, but they make it possible to purchase a house you'd otherwise be unable to afford.
Unfortunately, not everyone who wants to buy a home can qualify for a mortgage. That's because lenders try to make certain you'll pay back your debt before they allow you to borrow. Depending on the lender and the type of loan, you'll likely need to provide a lot of documentation to prove you're qualified for a home loan.
Knowing in advance what to expect when applying for a mortgage is important so you can start readying your finances for home ownership long before you hit up open houses or talk with a realtor. You can also start getting documents together for potential lenders to examine and determine whether they'll approve you for a loan.
If you're not exactly sure where to start, this guide explains everything you need to qualify for a mortgage. Read on to find out the must-haves for getting financing for a new abode.
Different loan types have different rules
Loan qualification requirements depend on which type of loan you receive, so you'll first need to understand different categories of mortgage loans. Home loans can be broadly divided into two different categories: conventional loans and government-backed mortgages.
- Conventional loans are issued by private lenders without any government guarantees. Some, but not all, conventional loans are resold to government-sponsored entities.
- Government-backed mortgages are issued by private lenders but are guaranteed or insured by the government. If you don't repay the loan in full, the government makes the lender whole.
Each of these categories can also be broken down into various individual loans.
A few different government agencies insure or guarantee mortgages to help would-be homeowners get approved for loans. Some agencies cater to specific populations. Government-backed mortgages include:
- FHA loans: The federal Department of Housing and Urban Development (HUD) manages a mortgage insurance program operated by the Federal Housing Administration. FHA loans are some of the easiest mortgages to qualify for, especially as the down payment requirements are as low as 3.5%. But borrowers must pay for mortgage insurance both up front and over time, making it potentially more expensive than the private mortgage insurance that comes with low-down-payment conventional loans. Mortgage insurance, which protects the lender by ensuring full recovery of lost funds in case you default, costs 1.75% of the loan amount up front and 0.80% to 0.85% of the borrowed amount per year. FHA loans are especially popular with first-time borrowers, but anyone can get an FHA loan.
- VA loans: The federal Department of Veterans Affairs (VA) guarantees loans for current and former members of the military and their families. VA loans provide very favorable terms to eligible borrowers and have limited qualifying requirements. You can get a VA loan with no down payment so long as the home isn't worth more than you pay for it, and there's no minimum credit score to qualify. You also don't have to pay for mortgage insurance, although you do have to pay an up-front funding fee of of between .5% and 3.3% of the loan amount unless you fall within an exception for disabled vets or military widows or widowers.
- USDA loans: The Rural Housing Service (RHS) operates under the federal Department of Agriculture to guarantee loans for rural home-buyers with limited income who can't obtain conventional financing. The upside is that USDA loans require no down payment. The downside is that they charge a steep up-front fee of 1% of the loan amount (which can be paid off over the entire loan term) and an annual fee of 0.35%.
To get an FHA, VA, or USDA loan, you apply through private lenders who participate in the government programs. You don't get a loan directly through the government. You can expect relaxed requirements to qualify, but there are still certain hurdles you'll need to clear. For example, the home will need to be inspected to ensure it's in good condition and appraised to ensure that it's worth the amount you're borrowing. If a home does not meet minimum standards for health and safety, repairs may be required before a loan will be granted.
Conventional loans can also be broken down into different categories, including the following:
- Conforming loans are loans that adhere to a specific set of guidelines set by Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac are government-sponsored entities (GSEs) that buy mortgages from the original lenders that issued them. Many mortgage lenders don't want to keep loans they've issued for many years. Instead, they resell the loan to Fannie Mae, Freddie Mac, or some other entity that buys mortgage debt. Fannie and Freddie (and many other mortgage buyers) won't buy non-conforming loans that don't adhere to established standards. For example, borrowers typically need credit scores of at least 640, and their total debt, including mortgage payments, can't exceed about 43% of income.
- Non-conforming loans are loans issued by private lenders that don't adhere to guidelines set by Fannie Mae and Freddie Mac. The most common type of non-conforming loan is a jumbo loan,which is a loan that's bigger than what Fannie and Freddie would buy. For example, in 2018, Fannie and Freddie would not buy loans totaling more than $453,100 (or $679,650 for loans issued in Alaska, Guam, Hawaii, or the U.S. Virgin Islands). Loans are also considered non-conforming if they don't meet eligibility requirements set by Fannie or Freddie.
Qualified vs. non-qualified loans
When you apply for loans, they'll fall into two broad categories: qualified and non-qualified loans. Conventional and non-conforming loans could both be either qualified or non-qualified, depending on whether the lender meets the requirements for a qualified loan.
- Qualified loans are loans that meet requirements established by the Consumer Financial Protection Bureau to ensure lenders do their due diligence to determine whether a borrower is qualified. Qualified loans also can't have risky features. For example, a lender can't give you a loan with payments so low that they only cover interest, as paying interest only never reduces the amount you owe, and the loan is never repaid.
- Non-qualified loans don't meet CFPB guidelines. That doesn't necessarily mean they're bad, but it does mean borrowers should do more research to make sure these loans don't have unfair terms. Non-qualified loans may have more relaxed requirements to get approved than qualified loans.
Must-haves to qualify for a mortgage
Some of the basics you'll need in order to be approved for any type of home loan include:
- A reliable source of income
- A debt-to-income ratio that falls within permissible guidelines
- A fair or good credit score
- A down payment
Let's take a look at some of these key requirements, the specifics of which vary based on loan type.
A reliable source of income
One of lenders' biggest concerns is your cash flow. Lenders want to know you have money to pay back your loan, which means you need a steady source of verifiable income. This can come from:
- A salary from work
- Bonuses and commissions
- Self-employment income
- Alimony or child support
- Social Security income
- Qualifying investment income, including income from interest and dividends
- Income from rental properties
In most cases, lenders will only allow you to count income if you have documented proof that you've received the money for at least two years. If you get a one-time bonus, there's no guarantee you'll get this money again, so lenders don't consider it when determining whether you can borrow and how much you can borrow.
Providing proof of income and employment
Before the mortgage crisis in 2008, some lenders allowed "stated income" loans. That meant would-be borrowers told the lender their income, and lenders didn't do much, if anything, to verify it. Unfortunately, stated income loans were often called "liar's loans," because many buyers were dishonest about their earnings -- often at the urging of unscrupulous mortgage brokers.
These days, most lenders -- with limited exceptions, such as hard-money lenders -- require documented proof that you've earned the income you claim. This could include:
- Tax returns
- W2s or 1099 forms from employers or companies that pay your business
- Pay stubs
- Bank statements
There's also a chance your lender will contact your employer to verify that you still have a job. If a source of income can't be verified, the mortgage provider won't count it as part of the income used to determine if you qualify for the loan.
Your income is only one part of a lender's equation. That's because your debt also affects the likelihood you'll be able to repay a loan. If you're trying to borrow with a $50,000 income and $0 in debt, then you may be a better candidate than someone with a $100,000 income and $1 million in debt.
If your debt-to-income ratio is too high, lenders may not approve you for a loan because they fear your income is spread too thin and so you'll struggle to meet your obligations. This is a big problem for a lot of would-be home buyers with student loans.
How to calculate your debt-to-income ratio
To calculate your debt-to-income ratio (DTI), add up all your monthly debt obligations and divide this number by your gross income (your pre-tax income).
If your monthly debt payments add up to $2,500 and your gross monthly income is $5,000, then you have a 50% debt-to-income ratio because 50% of your monthly pay goes to creditors. The higher your debt-to-income ratio, the greater the risk of lending to you.
The front-end vs. the back-end DTI ratio
Many lenders calculate not only one debt-to-income ratio, but two: a front-end ratio and a back-end ratio.
- The front-end ratio equals the total cost of your home-related expenditures divided by your monthly gross income. Home-related expenditures that go into this calculation include the monthly mortgage payment you'd make if approved for the loan, property taxes, and insurance payments. Collectively, the payments that count toward determining the front-end ratio are called PITI, which stands for principal, interest, taxes, and insurance for your property and possessions.
- The back-end ratio equals the total cost of everything you owe on a monthly basis divided by your monthly gross income. It includes your student loan debt, your auto loan, credit card debt, and any other obligations. Because more monthly payments are considered in this ratio than in the front-end ratio, you'll likely have a higher ratio using this calculation.
Let's say you have a gross monthly income of $4,000; a total mortgage payment of $1,000 monthly, including principal and interest; property taxes that average out to $300 monthly; and insurance costs that average out to $100 each month. Your front-end ratio would be ($1,000 + $300 + $100) / $4,000 = 35%.
Now, lets say you also have $300 in monthly student loan payments, a $100 monthly credit card bill, and $200 in car payments. Your back-end ratio would equal ($300 + $100 + $200) + ($1,000 + $300 + $100) / $4,000 = 50%.
What debt-to-income ratio do you need to qualify?
According to the Consumer Financial Protection Bureau, your back-end ratio should not exceed 43% for qualified conventional mortgages. Smaller creditors -- those that made fewer than 500 mortgage loans in the past year and have less than $2 billion in assets -- can allow you to obtain a qualified mortgage with a higher debt-to-income ratio.
Large lenders can allow you to exceed this DTI ratio, but the mortgage will then be considered non-qualified, which means the lender won't meet the CFPB standards aimed at ensuring that lenders avoid high-risk loans. Some lenders allow you to obtain a conventional loan with a back-end DTI of up to 50%, while others have stricter requirements.
A front-end ratio of 28% or less and a back-end ratio of 36% or less is considered ideal and is the standard most lenders use to determine who will get the most competitive mortgage rates.
Fannie Mae and Freddie Mac requirements:
In May of 2017, Fannie Mae and Freddie Mac raised their maximum debt-to-income ratio to 50%.
The FHA generally requires a front-end ratio of 31% or less and a back-end ratio of 43% or less. However, borrowers with mitigating factors, such as good credit and documented cash reserves, could have a DTI as high as 50%.
VA loans typically require a 41% back-end ratio.
USDA loans require a 29% front-end ratio and a 41% back end ratio.
A fair or good credit score
Your credit score is determined based on your borrowing history. It takes into account:
- Your past history of making payments on time. If you've been 30, 60, or 90 days late, this hurts your score. Judgements against you for unpaid bills or charge-offs (where creditors give up on collecting) also damage your score, as do foreclosures and bankruptcies. Even a single late payment can reduce your credit score.
- The amount of available credit you've used. If you have $10,000 in available credit and owe $2,000, then your credit utilization ratio is 20%. If you have $10,000 in available credit and owe $5,000, you have a 50% utilization ratio. It's best to keep your utilization ratio below 30% -- and the lower, the better.
- The mix of different types of credit you have: Having multiple types of loans -- such as credit cards, student loans, auto loans, and/or a previous mortgage -- can help your score.
- The age of your credit history: The longer your history of borrowing money, the higher your score will be -- so long as that history is positive.
- The number of inquiries on your credit report: Each time you apply for credit, you get a hard inquiry on your report. These inquiries stay for two years. Too many inquiries in too short a period of time lowers your credit score.
What's considered a good credit score?
FICO scores range from 300 to 850. Here's how the score range breaks down in terms of what's considered a good score or a bad score.
- 300- 579: If you're in this range, you're considered to have poor credit, and it will be difficult or impossible to get a mortgage loan.
- 580-669: This is considered fair credit. You'll likely be able to qualify for some types of mortgages, but the terms won't be great. Government-backed loans may be easier for you to obtain than conventional loans.
- 670-739: This is considered good credit. You should have a variety of lenders to choose from, and the rates and terms they'll offer will be reasonable.
- 740-799: This is considered very good credit. You'll get favorable rates and terms from many lenders.
- 800-850: This is considered to be exceptional credit. You'll likely find it easy to qualify for a mortgage with the lowest rates and best terms from any lender.
VantageScore previously used a scale that went from 501 to 990, but with VantageScore 3.0 it changed to a range of 300-850 to be more in line with other models.
While it's confusing that you have multiple credit scores, there's a simple reason why: Equifax, Experian, and TransUnion -- the three major credit bureaus -- developed an algorithm for VantageScore in 2006 to compete against FICO. VantageScore is used by millions of lenders, and it takes less time for consumers to develop a VantageScore than a FICO score, as FICO's model requires around six months of credit history, while VantageScores are created after just a month or two of reports on borrowing behavior.
Unfortunately, you can't really choose which score a lender uses. Mortgage lenders decide for themselves whether to pull your VantageScore or FICO score.
What credit score do you need to qualify?
For both conventional loans (including those meeting Fannie and Freddie requirements) and most government-backed loans, the minimum credit score required is generally 620. USDA loans typically require a minimum score of 640, however, and some lenders will provide loans to borrowers with scores of 580 or lower.
For FHA loans, it's possible to qualify with a credit score of 500 to 579 with a 10% down payment. The VA also doesn't mandate that borrowers have any particular score, but it requires lenders to evaluate a would-be borrower's entire financial profile. And even the USDA will allow borrowers with lower scores to qualify with manual underwriting, which is a more thorough review of financial information.
A down payment
Finally, a down payment is one of the last key requirements necessary to qualify for a mortgage. A down payment is money you pay up front and out of pocket for the home.
Making a down payment ensures you have equity, i.e., an ownership stake in the house. With no down payment or a very low down payment, you're at risk of owing more money on the home than you could obtain by selling it. This could create a financial crisis if you need to move, because you wouldn't be able to repay what you owe.
Lenders typically want proof of where your down payment comes from. Acceptable sources of funds include:
- Checking or savings accounts
- 401(k)s or IRAs
- Investments including stocks or bonds
- Trust accounts
- Cash value life insurance
- Gifts, so long as the money isn't a disguised loan from friends or family
Lenders don't allow you to use a personal loan for a down payment on a home. However, you might be able to get a piggyback loan if you have good credit. This involves taking out two separate mortgages, one of which is valued at 80% of the home's cost. The other is used to pay some or all of your "down payment."
If you take a piggyback loan, it could be structured as an 80-10-10 loan, which would mean you borrow 80% of the home price on a first mortgage, take a second mortgage for 10% of the home's cost, and put down 10%.
Or, you could take an 80-20 loan, where you borrow 80% of the cost of the home in a first mortgage and 20% in a second mortgage. Eighty-twenty loans were much more common before the financial crisis and are now hard to find. Lenders don't like these loans anymore -- and borrowers shouldn't either -- because if you owe 100% of the value of your home, you could end up owing more than it's worth if there's even a small downturn in the market. If you can't sell your home for enough to pay off both loans, you can't move to pursue other opportunities -- or move if the home becomes unaffordable due to a loss of income -- so the risk of foreclosure is much greater.
How big of a down payment do you need?
The down payment you'll need to produce varies based on the loan. Most government-backed loans have low down payment requirements, and some may not even require a down payment at all.
For conventional loans, most lenders want you to have a 20% down payment. If you bought a $300,000 home, you'd need a down payment of $60,000.
In some cases, it's possible to put down a smaller down payment. In fact, Fannie Mae and Freddie Mac's guidelines allow private lenders to make loans to qualified borrowers who have a down payment as low as 3%.
If you put down less than 20%, however, you'll typically need to pay private mortgage insurance (PMI). You'll have to pay PMI until you owe only 80% of what the home is worth. If you want to ditch your PMI at this point, you'll need to ask your lender to remove it. If you don't make this request, your lender will automatically drop the PMI once you've paid the loan down to 78% of the home's value at the time you took the loan.
PMI protects the lender's investment if you get foreclosed on. You don't benefit from PMI, but you pay the premiums, which cost around 0.3% to 1.5% of the loan value annually. If you took a $280,000 loan on your $300,000 house and the PMI rates were 1.5%, PMI would cost you $4,200 per year (1.5% x $280,000), or $350 per month.
With a credit score of 580 or higher, the minimum down payment for an FHA loan is 3.5%. With a score between 500 and 579, you'll need a 10% down payment.
The FHA requires borrowers to pay a one-time up-front mortgage insurance premium equal to 1.75% of the home loan. You also owe annual premiums, which are divided by 12 and added to each month's mortgage payment. Premiums range between 0.80% and 0.95% depending on the length of the loan and the size of the down payment.
You will need to pay your annual PMI cost (paid on a monthly basis) for either 11 years or for the whole time you have the FHA mortgage, depending on your original loan amount and the size of your down payment. See these charts from the Department of Housing and Urban Development to find out if you'll have to pay forever or can stop paying mortgage insurance after 11 years have passed.
The VA does not require a down payment or mortgage insurance. However, there's a funding fee charged, which is equal to a percentage of the loan. Fees range between 1.25% and 3.3% depending on how great your down payment is and whether you're in the National Guard, reserves, or regular military.
No down payment is required for USDA loans. There is an up-front fee equal to 1% of the loan amount, and mortgage insurance totals 0.35% of the loan balance annually. You'll need to pay this 0.35% fee for as long as you have the loan.
Other requirements to qualify for a mortgage
Getting your finances in order is the first key requirement of getting a mortgage, but there are other steps you'll have to take, too. For example, you'll need:
- A home appraisal: The appraisal is necessary to determine the value of the home you want to buy so that the lender can determine whether you meet down payment requirements. The appraised value is also used to determine how much the bank will lend. If you agree to pay $300,000 for a home but the appraisal says it's worth $250,000, then the bank will base the terms of your loan on a home value of $250,000 and will not lend more than the home is appraised for.
- An inspection and a survey: Most mortgage lenders require that you arrange an inspection to make sure the home is structurally sound and a survey to ensure everyone is clear on exactly what you're buying.
- Title insurance: Title insurance protects you -- and the bank -- in case it turns out there's a dispute over exactly what you've purchased or in case there are outstanding claims on the property, such as a tax lien.
- Homeowner's insurance: You typically must provide proof that you've secured insurance on the home you're buying in order to close on a mortgage loan.
- Money for closing costs: Most lenders want to see that you have money in the bank to cover closing costs. Typical closing costs total between 2% and 5% of the purchasing price of the home.
When you come to closing, you will need a bank or cashier's check for your down payment and other costs. You can't bring a personal check to closing.
Buying a home is a big deal
Buying a home, and qualifying for a mortgage loan, is a big deal. You're making a long-term commitment to repay a substantial amount of money over multiple decades. Banks impose many requirements to make sure you're ready, and you should also take steps before making a home purchase to confirm you're fully financially prepared to take on this big responsibility.
If you are, owning a home can be a good way to build wealth. If not, your purchase can lead to financial disaster.